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How to get the benefit of Indexation?

When it comes to the taxation of debt mutual funds, the concept of indexation is applicable in long-term capital gains from such funds. You will incur a capital gain if the redemption value is higher than the amount you invested. Such capital gains will be considered long-term in debt mutual funds if the investment is redeemed after 36 months from the date of investment.

So, for example, if you invest Rs.1 lakh in debt funds and after 4 years you redeem the fund, which amounts to Rs.1.5 lakhs, the long-term capital gain incurred is Rs. 50,000.

On this long-term capital gain, a long-term capital gain tax is payable. However, the tax is calculated after applying for the indexation benefit.

What is the indexation benefit?

Inflation reduces the purchasing power of money. So, at the time of redeeming any investment, inflation needs to be considered. For example, if you have invested Rs. 100 in Year 1 and get a return of Rs. 110 in Year 5, the return is not exactly Rs. 10. This is because the purchasing power of Rs. 110 would have reduced with time. This is because of inflation

The indexation benefit is applied to the investment amount to tax your returns fairly, which factors in inflation. Basically, indexation helps you to calculate the new value of your investment, considering inflation and also help to get real capital gain.

Indexation benefit in debt mutual funds

In debt mutual funds, the long-term capital gains are taxed @20% with indexation benefit. As per the indexation benefit, the cost of acquisition or the investment amount is inflated to account for inflation over the investment period. It is calculated as follows

Indexed cost of acquisition acquisition = investment amount * (Cost Inflation Index in the year of sale / Cost Inflation Index in the year of purchase)

The cost of inflation index (CII) is the factor used to determine this value which is declared for every financial year.

The CII for the last 6 financial years is as follows –

(Source: https://www.incometaxindia.gov.in/charts%20%20tables/cost-inflation-index.htm)

Here’s an example of how the indexation benefit works in taxation of debt mutual funds –

So, instead of a capital gain of Rs. 50,000, indexation reduces the capital gain to Rs.28,676, thereby saving the tax liability from Rs. 10,000 to Rs. 5,735.20.

Take the extra advantage: Instead of ‘Three Indexation’, you can benefit from ‘Four Indexation’.

The concept of - “Four Indexation Benefit”.

If you time your mutual funds investment and redemption of debt funds correctly, you can try & get the ‘Four Indexation’ Benefit. Under this benefit, even if you hold the debt mutual fund for a little above three years, you get the indexation benefit of four years. This can happen if you time your investments closer to the financial year ending and redeem just after a new financial year has started. In fact, some close-ended debt mutual funds are usually launched in January or February only to be redeemed after March, 36 months later so as to get a 4-year indexation benefit!

The four-indexation benefit is available only if five financial years fall between the investment date and the redemption date.

Let’s understand with an example –

When considering the CII, you get the CII of four indexed years which reduces your taxability considerably. If, however, you would have redeemed the investment in March 2019 (Just 1 month before), i.e. before a financial year has started, you would have gotten the indexation benefit of three years only, not four years. In that case:

Just by waiting for a few days and redeeming after the start of a financial year, the four-indexation benefit can be availed.

So, understand the benefit of indexation and use it to reduce your tax liability so that your debt funds also act as tax-saving mutual funds.

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